September 23, 2008

Barney Frank Discovers Regulation!!!!

A. What you had was a lot of conservatives saying, oh, let's let them go belly up. And as I've said, as it turns out, looking at a dead belly isn't as enjoyable as they thought it would be.... their failure to regulate sensibly has so endangered the economy and so burdened it with bad stuff that it's become very vulnerable.

Q.So suddenly the government is in the business of intervening in corporate America. What does that mean?

A. The Republicans - their own philosophy blew up in their face. They were so extreme in their insistence that there be no government intervention that they have wound up provoking far more government intervention than the Democrats ever would have.

How did we get here? Let's review: In order to curry congressional support after their accounting scandals in 2003 and 2004, Fannie Mae and Freddie Mac committed to increased financing of "affordable housing." They became the largest buyers of subprime and Alt-A mortgages between 2004 and 2007, with total GSE exposure eventually exceeding $1 trillion. In doing so, they stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse.

Hearing from September 2003 on an administration proposal to alter the regulation of GSEs like Fannie Mae and Freddie Mac. See Congressman Barney Frank's opening statement, which begins at 4:40. It's rather amusing. Here's an excerpt of his opening statement:

I want to begin by saying that I am glad to consider the legislation, but I do not think we are facing any kind of a crisis. That is, in my view, the two government sponsored enterprises we are talking about here, Fannie Mae and Freddie Mac, are not in a crisis. We have recently had an accounting problem with Freddie Mac that has led to people being dismissed, as appears to be appropriate. I do not think at this point there is a problem with a threat to the Treasury.

I must say we have an interesting example of self-fulfilling prophecy. Some of the critics of Fannie Mae and Freddie Mac say that the problem is that the Federal Government is obligated to bail out people who might lose money in connection with them. I do not believe that we have any such obligation. And as I said, it is a self-fulfilling prophecy by some people.

So let me make it clear, I am a strong supporter of the role that Fannie Mae and Freddie Mac play in housing, but nobody who invests in them should come looking to me for a nickel--nor anybody else in the Federal Government. And if investors take some comfort and want to lend them a little money and less interest rates, because they like this set of affiliations, good, because housing will benefit. But there is no guarantee, there is no explicit guarantee, there is no implicit guarantee, there is no wink-and-nod guarantee. Invest, and you are on your own.

Now, we have got a system that I think has worked very well to help housing. The high cost of housing is one of the great social bombs of this country. I would rank it second to the inadequacy of our health delivery system as a problem that afflicts many, many Americans. We have gotten recent reports about the difficulty here.

Fannie Mae and Freddie Mac have played a very useful role in helping make housing more affordable, both in general through leveraging the mortgage market, and in particular, they have a mission that this Congress has given them in return for some of the arrangements which are of some benefit to them to focus on affordable housing, and that is what I am concerned about here. I believe that we, as the Federal Government, have probably done too little rather than too much to push them to meet the goals of affordable housing and to set reasonable goals. I worry frankly that there is a tension here.

The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disastrous scenarios. And even if there were a problem, the Federal Government doesn't bail them out. But the more pressure there is there, then the less I think we see in terms of affordable housing.

In that brief statement, the Editorial Staff counted the following:

Times M. Frank stated "there is no crisis": 4
Times M. Frank stated "there is no threat to the Treasury": 1
Times M. Frank averred the government has no obligation to investors in GSEs: 4
Times M. Frank stated his overriding concern that GSEs provide "affordable housing": 4

As Congress began again to work on legislation to strengthen oversight of Fannie Mae and Freddie Mac, two of the nation's largest mortgage finance companies, Alan Greenspan, the Federal Reserve's chairman, urged lawmakers today to impose sharp limits on the $1.5 trillion holdings of the companies.

Appearing before the Senate Banking Committee, Mr. Greenspan said the enormous portfolios of the companies - nearly a quarter of the home mortgage market - posed significant risks to the nation's financial system should either of the companies face extensive problems.

"We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of the government-sponsored enterprises, which concentrate interest rate risk and prepayment risk at these two institutions and makes our financial system dependent on their ability to manage these risks," Mr. Greenspan said. "To fend off possible future systemic difficulties, which we assess as likely if G.S.E. expansion continues unabated, preventive actions are required sooner rather than later."

Most of the assets in the portfolios are mortgage-backed securities that the companies find more profitable to hold than to sell in the secondary markets. Mr. Greenspan said those holdings did nothing to further the mission of the companies of providing market liquidity and lowering mortgage interest rates but was solely a method of increasing earnings.

In previous years, lawmakers have failed to approve legislation imposing stronger oversight of the companies and changing the way they do business. The two companies have been formidable lobbying forces and been able to block attempts made by lawmakers, often with the support of rival mortgage companies, to restrict them.

But some lawmakers say this year presents the best opportunity in a long time to adopt legislation as the two companies because both companies have struggled through accounting scandals.

Mr. Greenspan's testimony went beyond previous statements in which he has urged tighter scrutiny of the two companies. His approach towards the companies of heavier scrutiny and regulation stands in strong contrast to his overall deregulatory approach in other areas, like hedge funds, and that distinction was noted today by a handful of senators who questioned the need to force Fannie Mae and Freddie Mac to reduce their portfolios.

In several pointed lines of questioning, Senator Charles E. Schumer, Democrat of New York, criticized Mr. Greenspan's recommendation and called it both inconsistent with his other views on regulation and potentially damaging to the housing markets. Without identifying anyone in particular, he also suggested that some people who have advanced tougher regulation of the two housing finance companies are really pushing a broader agenda to eliminate the companies and their mission of providing affordable housing.

"I see an analogy to Social Security," Mr. Schumer said. "Social Security has a problem and there are ideologues who want to undo it. Fannie and Freddie have problems and there are ideologues who want to undo them. But there are ways to fix the problems short of what's been proposed. When the sink is broken, you don't want to tear down the house."

Indeed. And with that brief trip in the Wayback Machine, we resume the narrative:

It is important to understand that, as GSEs, Fannie and Freddie were viewed in the capital markets as government-backed buyers (a belief that has now been reduced to fact). Thus they were able to borrow as much as they wanted for the purpose of buying mortgages and mortgage-backed securities. Their buying patterns and interests were followed closely in the markets. If Fannie and Freddie wanted subprime or Alt-A loans, the mortgage markets would produce them. By late 2004, Fannie and Freddie very much wanted subprime and Alt-A loans. Their accounting had just been revealed as fraudulent, and they were under pressure from Congress to demonstrate that they deserved their considerable privileges. Among other problems, economists at the Federal Reserve and Congressional Budget Office had begun to study them in detail, and found that -- despite their subsidized borrowing rates -- they did not significantly reduce mortgage interest rates. In the wake of Freddie's 2003 accounting scandal, Fed Chairman Alan Greenspan became a powerful opponent, and began to call for stricter regulation of the GSEs and limitations on the growth of their highly profitable, but risky, retained portfolios.

If they were not making mortgages cheaper and were creating risks for the taxpayers and the economy, what value were they providing? The answer was their affordable-housing mission. So it was that, beginning in 2004, their portfolios of subprime and Alt-A loans and securities began to grow. Subprime and Alt-A originations in the U.S. rose from less than 8% of all mortgages in 2003 to over 20% in 2006. During this period the quality of subprime loans also declined, going from fixed rate, long-term amortizing loans to loans with low down payments and low (but adjustable) initial rates, indicating that originators were scraping the bottom of the barrel to find product for buyers like the GSEs.

Naturally, the two presidential candidates are moving quickly to deal with this crisis -- that is, to blame it on everyone except themselves. John McCain and his surrogates are pushing the dubious notion that the primary problem is a lack of transparency and accountability. He might send someone down to Lehman's trading floor to ask the people packing up their desks whether they feel they've gotten away with something.

Meanwhile, Barack Obama is pointing the finger at John McCain, or at least Senator McCain's ideas...

This may play well on television, but it is rather disappointing coming from the man who promised us a new kind of politics. There have been no significant changes to the financial regulations in the last eight years that might credibly have created this crisis (the one major alteration, Sarbanes-Oxley, moved things in the other direction). And it's hard to blame loosened oversight when the entire market systematically overvalued the now-toxic securities. Lehman Brothers was not, after all, trying to put itself into receivership for the sheer joy of molesting taxpayers. The SEC is an extremely valuable agency, but even its crack regulators are not omniscient demigods who can instantly divine the "true" price of a complex security. Nor does it make sense to blame overpaid CEOs. Rick Wagoner's millions may be ill-deserved, but they did not force his customers to take out unreasonably large bank loans, nor compel investment managers to buy the securities into which those loans were packaged.

But both candidates are right about one thing: America's financial regulatory structure is badly outdated, and in need of a massive overhaul.

I'm not so sure the record bears her out on the question of loosened oversight. The problems we faced last week were twofold: GSEs were allowed to crowd other lenders out of the market by offering cheap, poor quality loans. But they could only do this so long as Congress was willing to turn a blind eye to their machinations. The price of Congressional acquiescence, it turns out, was "affordable housing". Had the 2005 regulatory reform bill been passed, it's arguable we would have experienced more sluggish growth, but averted last week's meltdown:

In 2005, the Senate Banking Committee, then under Republican control, adopted a strong reform bill, introduced by Republican Sens. Elizabeth Dole, John Sununu and Chuck Hagel, and supported by then chairman Richard Shelby. The bill prohibited the GSEs from holding portfolios, and gave their regulator prudential authority (such as setting capital requirements) roughly equivalent to a bank regulator. In light of the current financial crisis, this bill was probably the most important piece of financial regulation before Congress in 2005 and 2006. All the Republicans on the Committee supported the bill, and all the Democrats voted against it. Mr. McCain endorsed the legislation in a speech on the Senate floor. Mr. Obama, like all other Democrats, remained silent.

Now the Democrats are blaming the financial crisis on "deregulation." This is a canard. There has indeed been deregulation in our economy -- in long-distance telephone rates, airline fares, securities brokerage and trucking, to name just a few -- and this has produced much innovation and lower consumer prices. But the primary "deregulation" in the financial world in the last 30 years permitted banks to diversify their risks geographically and across different products, which is one of the things that has kept banks relatively stable in this storm.

As a result, U.S. commercial banks have been able to attract more than $100 billion of new capital in the past year to replace most of their subprime-related write-downs. Deregulation of branching restrictions and limitations on bank product offerings also made possible bank acquisition of Bear Stearns and Merrill Lynch, saving billions in likely resolution costs for taxpayers.

If the Democrats had let the 2005 legislation come to a vote, the huge growth in the subprime and Alt-A loan portfolios of Fannie and Freddie could not have occurred, and the scale of the financial meltdown would have been substantially less. The same politicians who today decry the lack of intervention to stop excess risk taking in 2005-2006 were the ones who blocked the only legislative effort that could have stopped it.

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Comments

What gets me is now we are supposed to look to Congress for a solution to this mess. Why should we look to Frank and Dodd when they were the ones creating this mess while taking campaign contributions from Fanny May and Freddy Mac. And of course this is all a failure of the free market system.

As I believe I alluded to in a previous thread that got hijacked about the mortgage crisis because your son is in the industry (full disclosure: so am I):

It was the federal government's request* that the GSEs expand home ownership that is the underlying problem. When you want to expand homeownership you can't expand into the good credit high down-payment segment. Those people have already bought homes. The only segment that can be expanded into are the high credit risk consumers.

Most lenders don't want this crap on their balance sheets and never did. The only reason the lenders originated the loans was that the GSEs told them *up-front* that they would buy any loan that met their criteria. Thus there would be absolutely no credit risk to the lender**. All risk was transferred off to the GSEs and to the once implicit and now explicit guarantee of the US taxpayer.

While the expansion was mandated under Clinton's watch, both parties have had majoraties in congress and neither one reigned in the problem.

*Which is about as voluntary as a Coach calling a 'voluntary' practice, which is to say it isn't.

**Until the GSEs not only decided to stop buying the loans, but also reneged are their agreement to buy the loans in the pipeline. When the GSEs stopped buying the lenders stopped originating, but those loans caught half-way have no where else to go but to the lender's balance sheet.

That's true, but there have been several attempts to address the problem. Part of the pain here is that no one wants to stall the economy by tightening credit.

What continues to piss me off is reading that people were able to get loans without even proving their income. WTF???

We have excellent credit. Always have. And also we have always bought near the bottom of what we can afford rather than at the top.

And yet no one has ever given us a home loan without us having to document exhaustively every last f***ing penny we earn. Both of us. So where do these jerks get off buying houses they can't afford and not having to show they can afford the payments? And then they have the colossal nerve to COMPLAIN they weren't warned? What moron takes out a mortgage without knowing what the payment will be?

I'm sorry, Yu-ain, but these are adult decisions. I'm living in a house that isn't nearly as nice as what we can truly afford precisely because we DIDN'T want to get caught in this kind of idiotic situation and didn't wait around to be "told" what we can and cannot afford. And when people's life savings are put at risk due to these people's negligence, I start to get a bit testy.

I will have more to say about this later :p Not fussing at you - just irritated at some of the dumb-assery I am reading.

I'm interested in hearing more, particularly about solutions (and pitfalls to avoid in those solutions). Finance is something I have never really understood (beyond personal finance, that is -- I know not to go into debt unless it's unavoidable, to pay it off as soon as possible, and to save whenever you can).

Pile, I wouldn't really lay much blame on the CRA. The CRA only requires that a 720 credit score, 80% Loan-to-Value, 35% Debt-To-Income loan on a $100k house (an excellent credit risk) is treated the same regardless of whether the customer lives in Beverly Hills or the inner-city.

It does not say that you have to lower your credit standards to keep a certain percentage of your balance sheet in any given area. Though some individual regulators could interpret it as such. (Despite official protestations to the contrary, regulatory interpretation and hence compliance, depend heavily on your individual regulator).

That's true, but there have been several attempts to address the problem. Part of the pain here is that no one wants to stall the economy by tightening credit.

I believe I basically said this. It was a poison-pill that had some really nice short-term side effects. We set up a house of cards and everyone kinda knew it would fall over some day, just nobody thought it would be *this* day.

What continues to piss me off is reading that people were able to get loans without even proving their income. WTF???

There are actually a couple of reasons for this.

1) There are people (largely small business owners and employees) who's income may be fairly high, but also unstable, think A/C repairmen in Florida. (Lenders do check that the stated-income is reasonable for the customer's job.) Some customers will save up for the slow season, other won't. It is very hard to tell from a W-2 which is which. But this does cause higher risk. Therefore lenders restrict other credit criteria to off-set in addition to charging a much higher interest rate.

This is a rather standard credit-risk tradeoff. If you have set your trade-off correctly, the stated-income portfolio will perform *as good or better* than your full-doc loans. But make no mistake, the industry knows they are high risk. Helk, the industry itself calls them "liar loans".

2) Stated-income loans is one of the ways the GSEs were able to follow congresses direction on "affordable housing". And again, as stated previously, it the GSE is going to take all the risk why wouldn't a lender make the loan. He takes a quick profit for 0 risk. There's no better risk/reward ratio around. What else would you expect them to do?

We have excellent credit. Always have. And also we have always bought near the bottom of what we can afford rather than at the top.

And likely got a darned good interest rate for it.

And yet no one has ever given us a home loan without us having to document exhaustively every last f***ing penny we earn. Both of us.

Likely because you wouldn't have accepted the Prime+4% it would have cost you to get around it.

So where do these jerks get off buying houses they can't afford ...

People have always tried to stretch what they could afford. Why do you think mortgage terms moved from 15 years to 30 years? Why do you think we've moved from Fixed-rate only to ARMs?

...and not having to show they can afford the payments?

As before, employment is verified and income is checked for reasonableness (A HVAC tech claiming $200k income is rejected) plus they are required tighter restrictions on all other credit criteria and pay a higher price.

And then they have the colossal nerve to COMPLAIN they weren't warned?

People have also been blaming everyone else but themselves for their own mistakes for a long time, too.

What moron takes out a mortgage without knowing what the payment will be?

Oh, they know what the payment will be. Lenders are required, by law, to give estimated payments. So the borrower knows the payment, they just believe they can make them. At least for the 2-3 years it will take for the property to appreciate enough to turn a profit. And for years, that was true. But now, 3 years after purchase when their savings have depleted, the property is worth less than what they paid and there is no refi opportunity to save them like there had been.

Was it a bad bet. You betcha. But it was also one that many people had won 2 or 3 times already and got lulled into a false sense of security.

I'm sorry, Yu-ain, but these are adult decisions. I'm living in a house that isn't nearly as nice as what we can truly afford precisely because we DIDN'T want to get caught in this kind of idiotic situation and didn't wait around to be "told" what we can and cannot afford.

So did I. And for the same reasons. But this also puts us in the top eschelon of credit risk of all borrowers. As much as we were to wish otherwise, we just aren't normal. Normal is broke.

Which people's negligence? The congress critters directing the GSEs to lower credit standards, the banks who accepted the low-risk/high-reward congress handed to them on a silver-platter through the GSEs, or the borrowers who made bad decisions?

Well, I will be happy to bore anyone who wishes to be bored senseless on this subject ;p

I would be delighted to be bored senseless on this subject. I think I've learned more about the financial system in the last week than in all my previous years but every time I turn around there's something else I don't understand. Today it's Credit Default Swaps which are giving me a terrible headache.

Should we do nothing and let the whole thing fall down? If we have to do something why can't we buy part of people's mortgages directly (with some pain for the homeowners and the lenders) instead of buying the mortgage-based assets? Yes, people like Cassandra (and me) who live in far less house than we could have leveraged and people who are renting because they know they can't afford to buy will get a raw deal compared to people who bought too much house and get bailed out. But aren't we all going to get a raw deal if we have to cough up for the Paulson plan anyhow?

BTW, I read the Megan Mcardle post you linked to and I found this paragraph:

America's entire approach to regulation is a relic of the New Deal, when optimistic Keynesians still believed that they might tame the economy by getting bright technocrats to run it. Seventy-five years later, we know that an economy of 300 million people is too complex to be controlled by any institutions, no matter how well-intentioned or well-managed. But our regulatory bodies still function on the dream that we can find bright public servants to wring all of the risk out of the system by carefully inspecting each product and certifying its quality.

Surely the idea that "bright technocrats" will save us by figuring out what assets to buy and how much to pay for them is the very basis of Paulson's plan. I'm just not getting a good feeling at all about this whole bailout.

Ya know, when I was looking to buy my house in the fall of '98, I benefited from Fannie Mae, although that's not who I made my mortgage to. One thing I thought at the time was that I was pre-approved for way more than I thought I could handle as a monthly mortgage payment. Lucky for me, I found a cute little starter home about $20k less than that pre-approved amount. Now, with what is happening, I see why I was probably approved for that (and, yes, I did have to provide proof of income). Guess my choice makes me a responsible one. I sold my house when I moved back to Texas. With the way things are now, whenever I would ordinarily be ready to buy another home, I'm not sure I'm going to be able to. The ease with which so many people could get a mortgage artificially inflated home prices, and now, credit is going to be tight for some undetermined period of time. Responsible people get screwed, and the irresponsible ones are going to be getting off the hook with little or no consequence for their decisions...

The high cost of housing is one of the great social bombs of this country. I would rank it second to the inadequacy of our health delivery system as a problem that afflicts many, many Americans. We have gotten recent reports about the difficulty here.

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